"Normalisation of Deviance" ..... not a comment on the moral deterioration of mankind, but when applied to markets a pointer to possible catastrophe in the future....

Wednesday 22nd July 2015

 "Normalisation of Deviance" ..... not a comment on the moral deterioration of mankind, but when applied to markets a pointer to possible catastrophe in the future....

"Electronic trading is out of control and heading for disaster" by Philip Aldrick, The Times, p.43

 Regulars will recognize that the subject of the dangers presented by the use of computer algorithms and high-frequency trading programmes that have come to dominate trading practices is not a new one for us. The catchy phrase in the title may be however, and originally derives from an acceptance of risk by NASA that ultimately led to the space shuttle disasters -- a parallel that should certainly get most people's attention.

It's a global phenomenon, but to take the UK as an example .... more than half the trades in equities, foreign exchange, government bond and futures markets are executed automatically, with computers replacing the "old-fashioned" methods of phone calls and human decision-making.

At first glance, things might appear healthy enough. The spread between bids and offers has never been tighter, and the numbers of orders give the impression of a thoroughly liquid market. Sadly, experience should have taught us that this is just an illusion. Computer-generated programmes tend to switch themselves off in the face of what they might consider an excessive move which renders their programme briefly redundant. Frankly, these moves in themselves don't have to be particularly large by previous standards but as the bids (almost always) and offers (conceivably) disappear, huge "air-pockets" are left behind which inevitably leads to hugely exaggerated price movements.

It's not as though we are short of recent examples, and in every market. In May 2010, the US stock market fell by 10% in 36 minutes. In October 2014, US Treasuries crashed in five minutes. In January this year, the Swiss Franc rose 28% (versus the Euro) in 20 minutes. And just this week, we've seen another "flash crash" in Gold.

 In each case there was a trigger for the move, but as Mr Aldrick points out these triggers were relatively modest affairs. What would happen if a real crisis occurred ? Some people might find it tempting to think that mature markets tend to sort themselves out in quick time, and that these matters are really only of interest to those in the financial markets. Tempting maybe, but utterly misguided. To quote Mr Aldrick again : "The 2007 credit crunch was caused by a liquidity freeze, the catalyst for Northern Rock's nationalisation. With no one trading, asset prices collapsed, punching huge holes in bank balance sheets. Facing losses, they stopped lending and plunged the world into recession." Get the picture ? The stakes couldn't be higher.....

It's not as though the authorities are unaware of the issue. Senior officials at both the Federal Reserve and the Bank of England have publicly acknowledged the problem but at the same effectively admitted that they're not sure what to do about it. More study needed into the new market dynamics seems to be the line. One can sympathise insofar as it's become a very difficult problem to solve but surely they need to fully apply themselves to it rather than just tinker around, and to do it right now . Otherwise, another older phrase might apply .... something to do with "fiddling" and "Rome burning."